http://research.stlouisfed.org/publications/es/09/ES0924.pdf
The term London interbank offer rate (Libor) is the
rate at which banks indicate they are willing to lend
to other banks for a specified term of the loan. The
term overnight indexed swap (OIS) rate is the rate on a
derivative contract on the overnight rate. (In the United
States, the overnight rate is the effective federal funds rate.)
In such a contract, two parties agree that one will pay the
other a rate of interest that is the difference between the
term OIS rate and the geometric average the overnight
federal funds rate over the term of the contract. The term
OIS rate is a measure of the market’s expectation of the
overnight funds rate over the term of the contract. There
is very little default risk in the OIS market because there
is no exchange of principal; funds are exchanged only at
the maturity of the contract, when one party pays the net
interest obligation to the other.
The term Libor-OIS spread is assumed to be a measure
of the health of banks because it reflects what banks believe
is the risk of default associated with lending to other banks.
Indeed, former Fed Chairman Alan Greenspan stated
recently that the “Libor-OIS
remains a barometer of fears of
bank insolvency.”
